Europe banks get downgrade warning amid 'bail-in' concerns

Credit ratings for European lenders could be slashed by one or two notches as the move towards "bail-ins" away from government "bailouts" continues to evolve, a leading credit agency has warned.

Following similar moves in the U.S., European banks could lose top investment grade ratings if regulators continue to look at ways to avoid taxpayers having to prop up struggling banks, as they did at the height of the global financial crash of 2008.

The warning comes from credit rating agency Standard and Poor's (S&P) which signaled that it would review its ratings on banks by the end of April this year.

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"We currently consider that subsequent medium-term rating actions would likely affirm or lower ratings by one or two notches depending on a bank's ability to adapt to the reforms," the company said in a press release on Tuesday afternoon.

The European Central Bank is currently undertaking an overhaul of the way Europe's banks are overseen. Tests to ensure the banks hold enough capital to be able to withstand future market shocks will to pave the way for a banking union. The ultimate aim is to prevent failing banks from crippling public finances.

One of the points under discussion is how banks are rescued in the future if they are on the verge of imminent failure. Rather than forcing governments - and therefore taxpayers – to bear the cost of rescuing failing banks, bail-ins" force losses on a bank's creditors. Cyprus became a testing ground for the practice in 2013 when one of its banks failed.

"Bail-ins" target creditors like bondholders. In some cases they are asked to defer repayment deadlines and can even agree to reduce their claims. If this becomes more widespread it could drive up the interest charged by bondholders, with credit ratings seeing these as riskier investments.

Some have warned that bail-ins could also damage the wider economy as it could mean that banks have to charge higher interest on their lending as a result.

S&P said developments in the U.S. towards "bail-ins" meant that its rating outlook on eight U.S. banks had already been impacted. It's now turning its sights to changes touted in Europe, with the European Union's proposed recovery and resolution legislation nearing finalization.

"In our review of European bank ratings, we will assess the scope of the proposed resolution regime, the degree of policy flexibility that the government retains, and the level of sovereign support that we may already include in the ratings on such instruments," it said.